Identifying the Channels Through which Regulatory Changes Affect Jobs

The Environmental Protection Agency is scheduled to release new regulations restricting the emissions of greenhouse gases (GHGs) from existing electrical generating units (EGUs, or power plants) next week. These new regulations will almost surely inspire a lot of debate over their effect on economic growth, and particularly on employment.

It is important to note first that the overall desirability of these proposed changes is dominated by their impact in forestalling global climate change. In strict economic terms, this consideration dwarfs any plausible estimate of the rule’s impact on jobs. Yet joblessness and weak labor markets continue to loom large as chief concerns of Americans (as well they should), and debate on these grounds will surely continue. Given this, even though the employment impacts of the rule are small relative to the environmental impacts, they still should be examined correctly.

Employment channels: Net versus gross and short versus long-runs

This blog post details the various channels through which environmental regulations have the potential to affect employment levels in the U.S. economy. To begin with, the effect of regulations on the net level of overall employment in the U.S. economy is the result of the sum of larger gross employment gains and losses across industrial sectors. So, for example, even if analysis finds that the new regulations will result in small net employment gains nationwide, this does not mean that no jobs in the U.S. economy will be lost due to the rules. Instead, it simply means that the total sum of employment gains and losses across all sectors is positive.

For policymakers, in fact, it could be argued that the size and composition of gross employment gains, and particularly losses, are much more important to take into account than the net employment impact. While it is comforting for macroeconomists to argue that job losses in one sector (either industrial or geographic) of the country are matched by job gains in another sector, it is obviously not the case that the same peoplewho lost jobs seamlessly moved into the new job openings. Gross job losses, even if counterbalanced by gains in other sectors, inflict real economic pain, and an optimal climate change policy would aim to ameliorate this pain.

It should also be noted at the outset that the net job impacts of regulatory changes are very different depending both on the time horizon examined as well as the macroeconomic context. The following section sketches out the differing employment effects over these different time horizons and macroeconomic contexts.

Employment effects in the short run in economies with excess capacity: possible changes in national employment levels

I’ll start with an overview of the channels relevant to the U.S. economy today, which is characterized by chronic excess capacity and historically high rates of joblessness, even five years after the Great Recession ended. Under these conditions, the impacts of regulatory changes even on nationwide net employment can be non-trivial. Given this context, the impacts of regulatory change occurring in an economy with chronic excess capacity should not be minimized.

What follows draws heavily on a previous paper that provided background and analysis on the proposed toxics rule, which would limit toxic emissions from EGUs.

The first channel through which the regulatory changes could affect economy-wide employment is their effect on employment in the directly regulated industries themselves. In the Regulatory Impact Analysis (RIA) prepared by the EPA for the mercury and air toxics rule, the work of Morgenstern, Pizer, and Shih (MPS) was used to assess these direct effects. MPS identify three sub-channels through which regulatory changes can affect the directly-regulated industries.

First, they note a production-cost effect that actually boosts employment by raising the per unit cost of production. Their example is that cleaner operations of an industry may involve more inspection and maintenance activities, boosting the employment required for each dollar of output (which is another example of regulatory changes reducing measured productivity). They label this the “cost effect.”

Second, they note that new “environmental activities” required to be performed by the regulated industry may be either more or less labor-intensive than the core activities of the industry, which can either boost or lower employment per dollar of output. They call this the “factor-shift” effect.

Third, they note that as production costs rise in response to increased environmental regulation, output prices for the industry will rise and the demand for industry output will decrease. They label this the “demand effect.”

Given the high-quality of the MPS framework, this would likely be a useful way to proceed here as well. I supplemented the work of MPS with evidence on import-intensity and price elasticity of demand that was available from other public (i.e., not from the RIA) sources to assess whether or not there was any reason to think that the MPS results were likely to overstate or understate any employment impacts.

The second channel through which regulatory changes can affect economy-wide employment runs through the construction of alternative energy generating sources and/or the installation of pollution abatement and control (PAC) equipment to comply with the new regulations. In assessing the employment impact of this channel, it is important to not just count the direct jobs spurred by this net new spending, but also jobs in supplier industries that are supported by industry spending.

A third channel runs through the effect of higher costs at power plants filtering through to higher prices for the goods whose production uses energy, which could lead to households cutting back consumption in response to this higher overall price level. We should note this is subtly different than the “demand effect” associated with the MPS channels above. That demand effect identified by MPS is partial equilibrium, and includes only demand for the output of the regulated industry. The effect that we are identifying here is a general equilibrium effect that takes into account the fact that some of the partial effect of higher utility prices might be counter-balanced by increased demand for non-utility prices because of relative price impacts (the example we provided before on finding substitutes for aluminum if regulation causes its price to rise).

Properly assessing the empirical bite of this general equilibrium channel is, however, quite difficult (for a full accounting of the difficulties, see this 2012 paper). Often, the full impact of price increases spurred by rising energy costs is assumed to filter one-for-one into rising prices economy-wide, and these rising prices reduced household demand for goods as goods became more expensive.

Yet both of these assumptions (full pass-through to prices and a one-way cause from a higher price level to reduced demand) are likely inappropriate for the U.S. economy today. For one thing, there are ample reasons to believe that a rise in the cost of energy spurred by regulatory changes will not raise prices economy-wide in an economy with such high levels of productive slack. Further, even if a rise in the price level did occur, it is not obvious that these higher prices would unambiguously reduce demand in an economy with ample productive slack. In fact, much recent research has come to the opposite conclusion.

Finally, the net of all of these previous channels would be subject to “multiplier” effects that characterize economies with lots of productive slack. Essentially, if the net of these first-round channels is positive (meaning jobs are created on net at the national level), then these jobs will spur new spending throughout the economy and will cascade through other industries to supply this newly-created demand. If the net of the previous channels are instead negative, this cascade will go into reverse the full employment loss would be larger than the sum of the previous channels indicate.

Employment impacts of regulatory changes over the long run in well-managed economies: Mostly a matter of composition

In the long run and during times when the economy is well-managed, the impacts of environmental regulations – even those with quite large gross compliance costs – on total net national employment will be quite small, essentially indistinguishable from zero. There are a number of reasons for this small net, overall employment effect.

First, in the long-run, energy-using industries would have time to adjust inputs to reflect changing relative prices (say, substituting more capital and labor for energy inputs as regulatory changes make energy more expensive). Granted, there is far from unlimited scope for doing this, but in the long-run one could surely imagine labor-intensive investments in energy efficiency being substituted for some margin of energy use by both households and businesses.

Second, job losses that are likely to occur in energy-intensive industries (and their supply chains) that experience falling demand for their output fall due to rising energy prices may be offset in part by job gains in non-energy-intensive industries that benefit from changed consumption patterns induced by the regulatory change. Say, for example, that rising energy costs increase the cost of (the very electricity-intensive) aluminum, some of this rising cost will be dealt with by aluminum users by demand more of goods that can serve as an aluminum substitute.

The most important reason why the overall employment impact of regulatory change is zero in the long run in a well-managed economy is the fact that national employment levels at any point in time are essentially set by the gap between aggregate demand (demand for spending stemming from households, businesses and governments) and the economy’s productive capacity (which is determined by the capital stock and labor force). So long as policymakers manage to keep the level of aggregate demand close to potential supply, then there will low unemployment. If, on the other hand, policymakers fail to keep aggregate demand from lagging behind potential supply growth, then employment would fall and vice-versa.

What this means in the context of regulatory changes is that in a well-managed economy any depressing effect on aggregate demand stemming from regulatory changes (declines in consumers’ purchasing power driven by increased energy prices, for example) could be potentially offset with other macroeconomic policy levers—reducing interest rates to spur business investment, for example, or increasing public spending on infrastructure projects. Hence, in the long run and in a well-managed economy, one should expect no aggregate job losses to stem from regulatory actions like proposed limits on GHG emissions from EGUs.

Small employment impact doesn’t mean small economic impact

This does not mean, of course, that any regulatory change is costless over the long-run in well-managed economies. For one, these changes are likely to reduce measured productivity in the economy because they will tend to require more input-intensive production.[1] This reduction in measured productivity will be transmitted to the rest of the economy through an increase in energy prices that pushes up the overall price level. In turn, this increase in energy prices cuts the purchasing power of workers’ wages, which could lead to voluntary reductions in hours supplied to the labor market by American workers. So, in the long run, and in a well-managed economy, while there would be no net job loss in terms of fewer jobs available for willing workers, there could well be fewer willing workers as labor supply declines.

Further, the fact that there is no rise in aggregate involuntary unemployment does not mean, of course, that each and every industry escapes job losses. Some industries will see job losses (energy-producing industries and their supply chains and heavy energy-using industries and their supply chains). Others have a chance to see job gains (light energy-using industries and some that provide alternative sources of energy generation that do not emit the regulated substances).

It is vital that workers in job-losing industries be helped with complementary policies to both ease transitions and to secure alternative employment. This means, in turn, that it is important to understand the channels through which regulatory changes will change the composition of employment over the long run, even if it is unlikely to affect the overall level.

Channels of changing employment composition

The first employment channel that will affect the composition of employment in the long-run will essentially consist of the employment impact borne by the directly regulated industry and its supply chains. This will be the sum of the cost, factor shift, and demand effects introduced earlier.

A second employment channel that will affect the composition of employment in the long run will be through international trade. If the rule disproportionately boosts output prices for tradeable goods, this could increase the trade deficit by causing a decline in net exports, which would disproportionately displace jobs in sectors that are energy-intensive and competing with imports.

The next employment channel would be the effect on labor supply of the rise in the overall price level spurred by the regulatory change. As the overall price level rises, real (inflation adjusted) wages should be expected to fall, and this will reduce the supply of labor economy-wide.

The final employment channel will consist of the employment generated by the countervailing macroeconomic impulse provided by policymakers to offset any impact the regulatory change has on the wedge between overall aggregate demand and productive capacity in the economy.

While at the national level it remains the case that in the long run in well-managed economies, regulatory action like the limits on carbon emissions from electricity generating units should not be expected to lead to overall job loss, knowing the composition of gross job gains and losses stemming for regulatory changes are vital for identifying what groups are due adjustment assistance and compensation in the wake of the rule.

Summing up

In the end, the costs and benefits of adopting the proposed rule will be dominated by its effectiveness in forestalling global climate change. Yet in the political realm, its effect on jobs will have a disproportionate role in the debate. If one wants to make jobs a centerpiece of debates over the effects of the proposed regulatory change, one should at least be comprehensive in tracing the possible channels through which employment might be affected. Future work will assess whether or not employment analyses of the proposed rule are indeed comprehensive.

[1] Note that “measured productivity” is the right way to think of this. Many of the economic benefits of environmental changes are not picked up in conventional measures of gross domestic product and hence would not be reflected in measured productivity, even though they do indeed improve welfare.

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